Cost and Benefit Analysis: Ka-Fu Wong

Cost and Benefit Analysis
Ka-fu Wong
University of Hong
Kong
1
Will you pick up the check?
o There is an opportunity for you to pick up a check of
$1000 at the city hall. The ticket to enter the city hall
costs $800.
o Yes?
o No?
2
Will you pick up the check?
o There is an opportunity for you to pick up a check of
$1000 at the city hall. The ticket to enter the city hall
costs $1200.
o Yes?
o No?

3
The Cost-Benefit Principle
• A rational individual (or a firm or a society) should take

an action if, and only if, the extra benefits from taking
the action are at least as great as the extra costs
Should I do activity x?
C(x) = the costs of doing x
B(x) = the benefits of doing x
If B(x) ≥ C(x), do x; otherwise don't.
4
The Cost-Benefit Principle
• A rational individual (or a firm or a society) should take

an action if, and only if, the economic surplus from
taking the action are larger than or equal to zero
Should I do activity x?
C(x) = the costs of doing x
B(x) = the benefits of doing x
If ES(x) = B(x) - C(x) ≥ 0, do x; otherwise

don't.
5
Rationality assumption
o People have goals and try to fulfill them as best as they
can.
o Firms maximize profit
o Consumers maximize utility (satisfactions) from
consumption.
o Governments maximize …
o Politicians maximize …
6
Inference, Prediction and, hence, Policy
o For rational individuals, actions are chosen to maximize some goals,
subject to their respective constraints.

o Prediction:
o Knowing a decision-maker’s goal and constraint, we can predict.
o Decision-makers: firms, consumers, …

o Inference:
o By observing their choice of actions, we can guess the goals and
constraints facing them.

o Policy:
o If we can change their goals (preference), and/or constraints, we can
cause them to choose a different action.
7
Policy
o If people are not doing the things we expect them to do, it must be
that they have a slightly different goals (slightly difference
taste/preference) and slightly different constraints from what we
assume.

o To encourage them to choose the action we expect them to do, we
would need to change their goals (preference), and/or
constraints.

o Teachers: What can we do to motivate students to learn hard?

o Students: What can we do to motivate teachers to teach hard?
8
Modelling the complex world
o We need a model to understand, predict, infer and make
policies.
o If we try to include all the details of the complex world, it will

take forever to build the model, and the resulted model will be
too complicated to be usable.

o The key is abstraction.
o Identify the most important elements in the complex world
and incorporate them (as assumptions) in the model.
Confront the model with data (things happened in the past).
o Continue to modify the model to improve the fit.
9
What is a good model?
o The assumptions made in the abstract model (e.g.,
some kind of rationality assumptions) may not include
some of the elements some of us consider important.

o The ultimate test of the model is how well it can fit the
data, how well it can use to predict, not how realistic the
assumptions are.
Friedman, M. “The Methodology of Positive Economics,” Essays In Positive Economics, Univ. of

Chicago Press, Chicago, 1953. 10
Will you go to the drama?
o Based on your experience, you are willing to pay $400 to
see 《 Principle 》 , a drama of Hong Kong Repertory
Theatre (in Cantonese). The price of the ticket is $250.
Will you go to see the drama?
o Yes?
o No?
11
Will you go to the drama?
o Based on your experience, you are willing to pay $200 to
see 《 Principle 》 , a drama of Hong Kong Repertory
Will you go to see the drama?
o Yes?
o No?

12
Inference
o Observed action:
o John pays a price of $250 to see the drama.

o Conclusion:
o It must be the case that John is willing to pay at least
$250 to see the drama.
o Or, the drama is worth at least $250 to John.
Yes! Observation of decisions/actions can allow us to deduce

the cost and benefit facing the decision-maker. The more
data, the more precise the estimate of cost and benefit.
13
Policy
o If we want more people to see the drama,

o we can advertise to change people’s preference
o so that they are willing to pay more to see the
drama.

o reduce the price of the tickets.
o Give people cash so that they have a bigger budget

to spend (?)
Which policy is more effective?
14
Advertise to change people’s preference
Number of people
Willingness to pay
15
Reduce the price of the tickets
Number of people
Willingness to pay
16
Who will change their mind due to a policy?
o Based on his experience, John is willing to pay $x to see
《 Principle 》 , a drama of Hong Kong Repertory
Will he go to see the drama?
Price = 250 Price = 190 Price = 270
x Decision x Decision x Decision
100 No 100 No 100 No
150 No 150 No 150 No
200 No 200 Yes 200 No
Marginal consumer
250 Yes 250 Yes 250 No
300 Yes 300 Yes 300 Yes
350 Yes 350 Yes 350 Yes
400 Yes 400 Yes 400 Yes
17
Who will change their mind due to a policy?
o Do not expect a policy to change the mind/decision of
everyone.

o Any policy can have impact only on people at the
margin.
18
Will you pick up the one-dollar coin?
o On your way to school, you see a one-dollar coin on the
road. Will you pick up the coin?
o Yes
o No
19
Will you pick up the two-dollar coin?
o On your way to school, you see a two-dollar coin on the
road. Will you pick up the coin?
o Yes
o No
20
Inference
o Observation:
o Yesterday, on her way to school, Mary spotted a one-
dollar coin but ignored it.
o Today, on her way to school, Mary spotted a two-dollar
coin and picked it up.

o Conclusion:
o Mary’s cost of picking up a coin is between 1 to 2 dollars.
1<C≤2
Remember! Observation of decisions/actions can allow us to
deduce the cost and benefit facing the decision-maker. The
more data, the more precise the estimate of cost and benefit.
21
Policy

o If we want more people to pick up something, increase
the benefit of that something.
o Some people will pick up $1 coins.
o More people will pick up $2 coins.
o Even more people will pick up $10 coins.
Don’t expect any policy will induce everyone to do the same!

Remember! Policy has impact only on people at the margin.
22
What to include and what not to include?
o You spend 100 dollars on meals every day. There is an
opportunity for you to pick up a check of $1000 at the city
hall. The ticket to enter the city hall costs $800. Should you
pick up the check?

o Yes?
o No?
o Do we include the 100 dollars on meals in our cost and

benefit analysis?
o B=1000, C=800
o B=1000, C=900
o Why or why not?
23
o You spend x dollars on meals every day. There is an
hall. The ticket to enter the city hall costs $800. Should you
pick up the check?

o Yes?
o No?
o Do we include the x dollars on meals in our cost and benefit

analysis?

o B=1000, C=800
o B=1000, C=800+x
For some x, wrongly including x as cost will cause us to make
a wrong decision!
24
hall. The ticket to enter the city hall costs $1200. By mistake,
you purchased the ticket to enter the city hall and it is
REFUNDABLE.
o Yes?

o No?
o Do we include the 1200 dollars in our cost and benefit

analysis?
o B=1000, C=0

o B=1000, C=1200
25
hall. The ticket to enter the city hall costs $1200. By mistake,
you purchased the ticket to enter the city hall and it is NOT
REFUNDABLE.

o Yes?
o No?
o Do we include the 1200 dollars in our cost and benefit

analysis?

o B=1000, C=0
o B=1000, C=1200
26

o Do not mechanically include any apparent benefit and
cost that will not be affected by your decision, at the
time of making the decision.
o Sunk cost is a cost that is beyond recovery at the

moment a decision must be made.
27
How many bowls of “leung cha” (herbal tea)
should I have?
https://multimedia.scmp.com/news/hong-kong/article/2162156/herbal-tea/index.html
28
How many bowls of “leung cha” (herbal tea)
should I have?

o The key is to convert the original decision to a sequence
of “Yes-No” decisions!
o Start from zero bowl. Should I have the first bowl?

o Start from one bowl. Should I have the second bowl?
o …
o Start from (n-1)-th bowl. Should I have the n-th bowl?
o I would have the n-th bowl if the marginal benefit of the

 n-th bowl is larger than marginal cost of the n-th bowl.
29
Thinking at the margin
o Actual trade-offs are usually at the margin.
Margin means additional
o MB(n-th unit): the additional benefit due to the n-th unit.

o TB(n units) – TB(n-1 units)
o MC(n-th unit): the additional cost due to the n-th unit.
o TC(n units) – TC(n-1 units)

o Should I do the n-th unit of activity X?
o Yes, if MB(n-th unit) ≥ MC(n-th unit)
30
o Assumptions:
o MB is non-increasing in additional units
o MB(5-th unit) ≥ MB(6-th unit) Fine Print as in your
o MC is non-decreasing in additional units bank statement.
o MC(10-th unit) ≥ MC(9-th unit)
31
o When goods or activities are perfectly divisible, the rule is

o do the additional ∆ unit of activity X if an only if
MB(additional ∆ unit | Q units) ≥
MC(additional ∆ unit | Q units)
o Let ∆ approach zero, the rule becomes

MB(additional ∆ unit | Q units) =
MB(additional ∆ unit | Q units): benefit from an additional ∆ unit given that we have Q units
32
When goods or activities are perfectly divisible, the rule is
o do the additional ∆ unit of activity X if an only if
MB(additional ∆ unit | Q units) ≥
o Let ∆ approach zero, the rule becomes
MB(additional ∆ unit | Q units) = MC(additional ∆ unit | Q units)
Suppose
MB(additional ∆ unit | Q units) > MC(additional ∆ unit | Q units)

o Increase quantity by a very small amount.
o Decrease quantity by a very small amount.
What is the impact on

MB(additional ∆ unit | Q units) - MC(additional ∆ unit | Q units)? 33
Allocation of caterpillar fungus
gatherers
Ophiocordyceps
sinensis is a
fungus that
parasitizes larvae
of ghost moths
and produces a
fruiting body
valued as an
herbal remedy.
(Chinese: 冬虫夏草 ;
literally "winter
worm, summer
grass").
http://en.wikipedia.org/wiki/Ophiocordyceps_sinensis 34
gatherers
o We have four gatherers. How many gatherers should
we send to the east or west side of the hill given the
average output as shown below?
Average output per gatherer (kgs)

Number of gatherers East side West side
1 10 13
2 10 12
3 10 11
4 10 10
35
gatherers
1 10 13
2 10 12
3 10 11
4 10 10
o Based on the average output per gatherer, we should send
o Zero to the East, and four to the West

o One to the East, and three to the west
To determine “how many”, we should look at

the marginals, not averages.
36
gatherers
1 10 13
2 10 12
3 10 11
4 10 10
Marginal output per gatherer (kgs)

1 10 13
2 10 11 (=24-13)
3 10 9 (=33-24)
4 10 7 (=40-33)
37
gatherers
Marginal output per gatherer (kgs)
1 10 13
2 10 11 (=24-13)
3 10 9 (=33-24)
4 10 7 (=40-33)
Should I send the first gatherer to the east (or the west)?
No. B(East 1) = 10 < C(East 1) = B(West 1) = 13
Should I send the second gatherer to the east (or the west)?
No. B(East 1) = 10 < C(East 1) = B(West 2) = 11
Should I send the third gatherer to the east (or the west)?
Yes. B(East 1) = 10 > C(East 1) = B(West 3) = 9
Should I send the fourth gatherer to the east (or the west)?
Yes. B(East 2) = 10 > C(East 2) = B(West 3) = 9 38
Allocation of fixed amount of resources (still
about thinking at margin)
o When allocating a fixed amount of resources among
several activities, allocate the additional unit of
resources to activities with the highest marginal benefits.
o When the resource is perfectly divisible and when the

MB of one activity is not always higher than the others,
allocate the resources such that
MB(∆ unit | A1)=MB(∆ unit | A2)=…=MB(∆ unit | An)
MB(∆ unit | An):

Benefit of doing a additional ∆ unit from (conditional on) the current total An unit.
39
Allocation of fixed amount of resources (still
about thinking at margin)
When the resource is perfectly divisible and when the MB of one
activity is not always higher than the others, allocate the
resources such that
MB(∆ unit | A1)=MB(∆ unit | A2)=…=MB(∆ unit | An)
Suppose at the current allocation of resources to the two activities
yields:
MB(∆ unit | A1)>MB(∆ unit | A2), or
MB(∆ unit | A1) - MB(∆ unit | A2)>0
o Take a very small amount of resources from A1 and move to A2

o Take a very small amount of resources from A2 and move to A1
Impact on MB(∆ unit | A1) - MB(∆ unit | A2)?

40
s ue
is
licy
Po Reducingthe death rate of the Prisoner
Transport Business
o In 1780s, the British government hired sea captains to ship
convicted felons to Australia.
o The captain was paid by the number convicted felons
boarding the ship in England for Australia.
o The British public had no love for the convicts. On one
voyage, more than one third of the men died and the rest
arrived beaten, starved, and sick.
o How do we reduce the death rate?
Pay the ship captains by the number of living

convict on arrival.
Ekelund, Robert B. Jr., and Edward O. Price III:
The Economics of Edwin Chadwick: Incentives Matter, Edward Elgar Publishing, Inc. 41
Reducing the death rate of the Prisoner
Transport Business
First, we need to understand the decision of the captains:
o Should the captain raise the number of surviving

convicts on arrival by 1 person?
o Yes, if the benefit of doing so is higher than the cost
of doing so.
42
Thinking on the margin in the Prisoner
Transport Business
o How many convicts should the captain keep alive?

o Should the captain keep alive the first convict?
o Should the captain keep alive the second convict?
o…
o Should the captain keep alive the n-th convict?
o Policy choice:
o Pay on boarding the ship in England

o Pay on arriving Australia
By paying the ship captains by the number of living convicts on arrival, the
benefit of keeping one additional convict alive is raised. Thus, the captains
will likely keep more convicts alive.
43
Reducing the death rate of the Prisoner
Transport Business
o In 1787, the British government had hired sea captains to ship
convicted felons to Australia.
o The British public had no love for the convicts. On one voyage,
more than one third of the men died and the rest arrived beaten,
starved, and sick.
o How do we reduce the death rate?
Policy and its impact:
 After the ship captains were paid per living convict on

arrival, the death rate fell from over 33% to less than
1%.
44
Incentives Matter
o Incentives: rewards and penalties that motivate
behavior.
o People respond to incentives in predictable ways.
o Self-interest is an important incentive in economics.
Policy-makers should structure an incentive

mechanism to maximize its intended impact.
45
Trade-offs are Everywhere
o For every choice something is gained, something lost.
o The opportunity cost of a choice: the value of the

opportunities lost.
o Includes monetary and nonmonetary costs
o Includes explicit and implicit costs.
46
Decision:
Will you help Uncle Fong?
After an exchange at OKU in England, you were about to return to
Hong Kong. You noticed that the Mr. Bean (a UK comedy television
programme) complete series DVD were sold at HK$1,800 at Hong
Kong stores and about HK$500 in England. You had been planning
to bring back a Mr. Bean DVD set and sell it at about HK$1,300.
Then Uncle Fong asked you to bring back a Mr. Bean DVD set, and
promised to pay you the cost of the DVD (i.e., HK$500). You value
the chance of helping Uncle Fong at $700. Will you help him?
(Assume you can only bring back 1 Mr. Bean DVD set.)
o Yes
o No
47
Imagine you have not yet purchased the DVD set.
o The benefit of helping Uncle Fong?
o Your valuation of helping Uncle Fong
= 700+500-500
= 700
o The cost of helping Uncle Fong?
o Helping Uncle Fong, you will lose the opportunity of bringing back
the DVD and reselling it yourself.
o What you could have gotten by bringing back the DVD and reselling
it yourself
= 1300 – 500
= 800
o Benefit – cost = -100 <0
 No, you should not help Uncle Fong
48
(An alternative calculation)
Imagine you are already back with the DVD set.
o Your valuation of helping Uncle Fong + reimbursement from
Uncle Fong
= 700 + 500
= 1200
o Helping Uncle Fong, you will lose the opportunity of reselling
the DVD yourself.
o What you could have gotten by reselling the DVD yourself
= 1300
o Benefit – cost = -100 <0
 No, you should not help Uncle Fong
49
Decision:
After an exchange at OKU in England, you were about to return to
Hong Kong. You noticed that the Mr. Bean (a UK comedy television
programme) complete series DVD were sold at HK$1,800 at Hong
Kong stores (e.g., HMV) and about HK$500 in England. You had
been planning to bring back a Mr. Bean DVD set and sell it at about
HK$1,300. Then Uncle Fong asked you to bring back a Mr. Bean
DVD set, and promised to pay you the cost of the DVD (i.e.,
HK$500). You value the chance of helping Uncle Fong at $900. Will
you help him?
(Assume you can only bring back 1 Mr. Bean DVD set.)
o Yes
o No
50
Imagine you have not yet purchased the DVD set.
o Your valuation of helping Uncle Fong
= 900
o Helping Uncle Fong, you will lose the opportunity of bringing
back the DVD and reselling it yourself.
o What you could have gotten by bringing back the DVD and
reselling it yourself
= 1300 – 500
= 800
o Benefit – cost = 100 >0
 Yes, you would help Uncle Fong
51
(An alternative calculation)
Imagine you are already back with the DVD set.
o Your valuation of helping Uncle Fong + reimbursement from Uncle
Fong
= 900 + 500
= 1400
o Helping Uncle Fong, you will lose the opportunity of bringing back
the DVD and reselling it yourself.
o What you could have gotten by bringing back the DVD and reselling
it yourself
= 1300
o Benefit – cost = 100 >0
 Yes, you would help Uncle Fong
52
Same decision, despite different approaches
of calculating the cost and benefit
o We may categorize the cost and benefit slightly
differently, but if we have included all the cost and
benefits properly, we should
o get the same Economic Surplus, and
o arrive at the same decision/conclusion.

53
Opportunity cost
o Opportunity cost of an activity is the value of the next
best alternative that must be forgone in order to
undertake the activity.
54
Opportunity cost of seeing Eason Chan
o You won two free tickets, one to see the concert by
Eason Chan, a local pop singer, and another to go to the
city hall to pick up a $1000 check. You cannot resell any
of these tickets (say, your photo ID will be checked at
entrance). The concert and the check pickup are on the
same night. Assume there are no other costs of either
seeing Eason Chan or picking up the check. Based on
this information, what is the opportunity cost of seeing
Eason Chan?
55
o You won three free tickets, one to see the concert by
Eason Chan, a local pop singer, one to go to the city hall
to pick up a $1000 check, and one to go to the library to
pick up $800 check. You cannot resell any of these
tickets (say, your photo ID will be checked at entrance).
The concert and the check pickup are on the same
night. Assume there are no other costs of either seeing
Eason Chan or picking up the check. Based on this
information, what is the opportunity cost of seeing
Eason Chan?
56
to pick up a $1000 check, and one to go to the library to
pick up $1200 check. You cannot resell any of these
tickets (say, your photo ID will be checked at entrance).
The concert and the check pickup are on the same
night. Assume there are no other costs of either seeing
Eason Chan or picking up the check. Based on this
information, what is the opportunity cost of seeing
Eason Chan?
57
to pick up a $X check, and one to go to the library to
pick up $Y check. You cannot resell any of these tickets
(say, your photo ID will be checked at entrance). The
concert and the check pickup are on the same night.
Assume there are no other costs of either seeing Eason
Chan or picking up the check. Based on this information,
what is the opportunity cost of seeing Eason Chan?
C(Eason) = max{X,Y}
58
The impact of having more alternatives
o We choose to do activity X only if the benefit of doing X
is larger than the cost of doing X. The cost of doing X
often include the benefit of doing the best alternative of
X.
o Suppose A1 is the only alternative available. Then,
assuming there is no other costs, the cost of doing X is
simply the benefit of doing A1.
C(X)=B(A1)
59
o Suppose we are given an additional alternative, say A2.
That is, if we do not to do X, we can doing either A1 or
A2.
o The cost of doing X now becomes maximum of benefit

of doing A1 and benefit of doing A2.
C(X)= max{B(A1),B(A2)}
60
o Suppose we are given an additional alternative, say A3.
That is, if we do not to do X, we can doing either A1, A2
or A3.
o The cost of doing X now becomes maximum of benefit

of doing A1, benefit of doing A2, and the benefit of
doing A3.
C(X)= max{B(A1),B(A2),B(A3)}
61
max{B(A1),B(A2),B(A3)} ≥ max{B(A1),B(A2)} ≥ B(A1)
o Given B(X), an increase in C(X) will cause

o either no change in the decision of doing X
o or a switch to not doing X
o Thus, availability of additional alternatives will likely

decrease people’s choice of activity X.
62
Why are there less students attending lectures
nowadays? (More students skipping lectures.)
o Should I attend a lecture?
o Thirty years ago, if I do not attend a lecture, I can go to

the canteen or go to the library.
o Now, if I do not attend a lecture, I can go to the

canteen or go to the library, or watch a movie online
(and possibly many more).
63
Similar questions:
o Why are students in Cornell University more likely to
attend lectures than students in NYU?
The availability of many fun

things to do in New York City.
64
Similar questions:
o Why has there been a reduction in the number of people
flying from Hong Kong to Xiamen recently?
The availability of high speed

rail as an alternative.
65
Good Institutions Align Self-interest with
the Social Interest
o Markets magically align your self-interest with social
interest (usually).
o Because the apple growers wants profit, you get your

apple!
66
Alignment of self-interest with
social interest
o Because Mr. WONG Wai Kay, Ricky of the City Telecom
wanted profit, we had call-back service in Hong Kong
and hence a lower rate of international calls.
o He supplied the call-back service because the benefit of

doing so is larger than its cost!
o Did he do it solely because he wanted to improve our

well-being?
67
“It is not from the benevolence
of the butcher, the brewer,
or the baker that we expect
our dinner, but from their
regard to their own
interest.”
-Adam Smith,
The Wealth of Nations
Adam Smith saw the invisible hand

68
Moral Sentiments as Commitment Devices
• Note that economists also emphasize moral sentiments.
• There are situations in which pursuit of self interest will yield
inefficient outcome.
– prisoner’s dilemma game yields inefficient outcome because
the lack of commitment
• If commitment problems cannot be solved by altering the
relevant material incentives, it may nonetheless be possible to
solve them by altering people's psychological incentives.
• For example, feelings of guilt when they cause harm to others,
feelings of sympathy for the interests of their trading partners,
feelings of outrage when they are treated unjustly, and so on.
• These feelings may lessen the incentive to behave in
opportunistic and mutually destructive ways.
69
Two Standards of Rationality
1. The Self-interest Standard:
– A person is rational if she is efficient in pursuit of her
own interests.
– The self-interest model appears inadequate in
explaining some real-world phenomena.
Return wallets Rescues Bone marrow Blood donation

donation
70
Two Standards of Rationality
2. The Adaptive Rationality Standard:
– A taste can be added to the self-interest model, but
only if people with such taste will not be penalized in
the long run, and acquiring such taste will not lead
to the extinction.
Return wallets Rescues Bone marrow Blood donation

donation
71
Institutions Matter
o Why are some countries rich and others poor?
o Incentives are sometimes lacking.
o Strong institutions that support these incentives foster

economic growth.
72
Can you tell North and
which South Korea
country has at night
better
institutions?
73
Can go fishing if ….
o If we have the right institution that foster the alignment
of self-interest with social interest,
o Government officials can go fishing!
74
Misunderstanding about the study of
Economics

o Economics is useless because its assumption of
rationality is not realistic.

o Economics cares only about money.
o Economics is bad because it teaches people to become

 selfish.
75
RIGHT or WRONG?
o In an apparently similar situation, you choose to do A, I choose to
do B.

o I am RIGHT! You are WRONG!
76
Acknowledging our differences
o If people choose options that differ from ours, it can be simply because
they have slightly different goals (slightly difference taste/preference)
and slightly different constraints from what we have.
o It is not about RIGHT versus WRONG. With economics training, we

 should be much more SYMPATHETIC about people making different
choices/decisions.
o If we want to understand why Peter, Paul and Mary choose an option

that differs from ours, it is important that we communicate with them
and try to understand
o the goal (slightly difference taste/preference) they have and
o the constraint they face.
77
Survey: Do you want an apple?
o We are simply asked “Do you want an apple?” Suppose
no other information is given.
o When we answer the survey question, what assumption
do most of us make implicitly?

o The cost of the apple is zero
o The cost of the apple is the same as the market price
(if there is one)
78
Survey: Do you want an apple?
o We are simply asked “Do you want an apple?” Suppose
no other information is given.
o Suppose everyone of the 100 persons surveyed said
“yes”.
o As an apple seller, how many apples do you expect to
sell if you charge $5 per apple?
o 100 apples
o Likely more than 100 apples
o Likely less than 100 apples
How much less?

We do not have enough information to conclude.
79
When an economist do a similar survey:
How much are you willing to pay for an apple?
o Suppose everyone of the 100 persons surveyed said “3
dollar”. As an apple seller, how many apples do you
expect to sell if you charge $5 per apple?
o Suppose everyone of the 100 persons surveyed said “0.1

dollar” to “10 dollars”, uniformly distributed. As an
apple seller, how many apples do you expect to sell if
you charge $5 per apple?
50
80
Reading of survey results with a grain of salt
o When we are told that Y% of people surveyed said they
like to have A, interpret the statement as
o Y% of people surveyed said they like to have A when
the cost of A is zero.
o When people realize that the cost of A is much higher
then zero, the percentage of people who would like
to have A will drop substantially – much less than Y
%.
81
Positive versus normative economic analysis
The study of economics helps us make
o Prediction
o Inference
o Policy
Most of the time, we are just doing positive economic analysis, i.e.,
without judgement on what you should do.
In contrast, normative economic analysis makes a judgement on what

other people should do.
82

Cost and Benefit Analysis: Ka-Fu Wong

Uploaded by

Document Information

Original Description:

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Cost and Benefit Analysis: Ka-Fu Wong

Uploaded by

Copyright:

Available Formats

Cost and Benefit Analysis

• A rational individual (or a firm or a society) should take

B(x) = the benefits of doing x

If B(x) ≥ C(x), do x; otherwise don't.

• A rational individual (or a firm or a society) should take

B(x) = the benefits of doing x

If ES(x) = B(x) - C(x) ≥ 0, do x; otherwise

o If we try to include all the details of the complex world, it will

Friedman, M. “The Methodology of Positive Economics,” Essays In Positive Economics, Univ. of

Yes! Observation of decisions/actions can allow us to deduce

o Give people cash so that they have a bigger budget

Which policy is more effective?

Don’t expect any policy will induce everyone to do the same!

o Do we include the 100 dollars on meals in our cost and

o Do we include the x dollars on meals in our cost and benefit

o Do we include the 1200 dollars in our cost and benefit

o Do we include the 1200 dollars in our cost and benefit

o Sunk cost is a cost that is beyond recovery at the

o Start from zero bowl. Should I have the first bowl?

o I would have the n-th bowl if the marginal benefit of the

Margin means additional

o MB(n-th unit): the additional benefit due to the n-th unit.

o When goods or activities are perfectly divisible, the rule is

o Let ∆ approach zero, the rule becomes

What is the impact on

Average output per gatherer (kgs)

o Based on the average output per gatherer, we should send

o Zero to the East, and four to the West

To determine “how many”, we should look at

Marginal output per gatherer (kgs)

o When the resource is perfectly divisible and when the

MB(∆ unit | An):

Impact on MB(∆ unit | A1) - MB(∆ unit | A2)?

o How do we reduce the death rate?

Pay the ship captains by the number of living

o Should the captain raise the number of surviving

o How many convicts should the captain keep alive?

o How do we reduce the death rate?

Policy and its impact:

 After the ship captains were paid per living convict on

Policy-makers should structure an incentive

o The opportunity cost of a choice: the value of the

o The cost of doing X now becomes maximum of benefit

o The cost of doing X now becomes maximum of benefit

o Given B(X), an increase in C(X) will cause

o Thus, availability of additional alternatives will likely

o Thirty years ago, if I do not attend a lecture, I can go to

o Now, if I do not attend a lecture, I can go to the

The availability of many fun

The availability of high speed

o Because the apple growers wants profit, you get your

o He supplied the call-back service because the benefit of

o Did he do it solely because he wanted to improve our

Adam Smith saw the invisible hand

Return wallets Rescues Bone marrow Blood donation

Return wallets Rescues Bone marrow Blood donation

o Incentives are sometimes lacking.

o Strong institutions that support these incentives foster

o Economics is bad because it teaches people to become

o It is not about RIGHT versus WRONG. With economics training, we

o If we want to understand why Peter, Paul and Mary choose an option

o Likely less than 100 apples